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The Investment Research Journal from barclays global investors

6.08 june 2008

volume 11 issue 3

Forecasting Fund
Manager Alphas:
impossible The just takes longer

by m. barton waring and sunder r. ramkumar

Reprinted from the financial analysts journal with minor changes.

june 2008 b
executive editors authors
Ronald N. Kahn M. Barton Waring
415 597 2266 phone Chief Investment Officer for Investment Policy and Strategy, Emeritus
415 618 1514 facsimile
Barton Waring ran BGI’s Client Advisory Group—delivering leading-edge
investment strategy and policy advice to the firm’s clients—from 1996
until his recent decision to retire, and continues in an advisory capacity
Matthew H. Scanlan
415 597 2716 phone in his new emeritus role. He has published more than two dozen articles
415 618 1069 facsimile on surplus asset allocation, manager structure optimization and risk budgeting, and defined contribution/individual investor investment
strategy. Barton serves on the Editorial Advisory Boards for The Journal
of Portfolio Management, the Financial Analysts Journal, and The Journal of
editor Investing. He received his BS degree in economics from the University
of Oregon, his JD degree from Lewis and Clark College, with honors,
Marcia Roitberg
415 597 2358 phone and his masters degree in finance from Yale University.
415 618 1455 facsimile Sunder R. Ramkumar
Client Advisory Strategist

Sunder Ramkumar is a strategist with BGI’s Client Advisory Group. He

advises our strategic clients on asset allocation issues, and is responsible
for developing optimal plan-level investment solutions. Sunder has also
conducted research for BGI’s advanced active equity strategies, and advised
on new product development for defined contribution plans. He received
an MS in management science and engineering with a concentration in
finance from Stanford University, and has a BE in mechanical engineering.
He is also a CFA charterholder.

We would like to express our appreciation to Laurence B. Siegel and Steven Thorley.
Their wise comments and suggestions helped us to significantly improve this article.

This article originally appeared in the March/April 2008, volume 64

number 2 issue of the Financial Analysts Journal. It is reprinted here
with permission from CFA Institute, © 2008 CFA Institute. The FAJ
can be found online at

c InvestmentInsights
Forecasting Fund
Manager Alphas:
The impossible just takes longer

Table of Contents
Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Why forecast alphas?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Forecasting fund manager alphas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

june 2008 1
Many investors (plan sponsors) balk at the suggestion of making explicit alpha
forecasts before hiring active fund managers. But in fact, fund manager alphas
can and should be forecast.

Active management is a zero-sum game (negative 4. The breadth of the portfolio, representing the
sum after fees and costs) where the performance number of independent active management deci-
of all active managers is distributed around—above sions made per year by the portfolio manager.
and below—the benchmark. Therefore, to win con-
5. The transfer coefficient, or implementation
sistently, a manager must have exceptional skill,
efficiency, of the portfolio, expressing the
enough to beat the others playing the game. Not
performance drag from constraints.
only this, but the plan sponsor is selecting managers
from this same zero-sum distribution, and so must 6. The expected active risk of the portfolio.
also have special skill—at identifying skillful active
7. The level of fees.
managers to beat the benchmark. So two levels
of skill, one at the manager level and one at the These variables, particularly the first two, require
sponsor level, are required for active management careful thought and research. Just as sponsors
to be successful. expect fund managers to be thorough in evaluating
stocks, so too sponsors must thoroughly evaluate
Both sponsor skill and fund manager skill can be
fund managers to develop meaningful forecasts.
quantified and incorporated into an explicit alpha
forecast in the framework developed in this article. Investors should be encouraged to use the above
By combining two equations set forth by Richard method for explicit alpha forecasting because it
Grinold—the “fundamental law of active manage- brings discipline and structure to the process of
ment” and a variation on the “forecasting equation”— building portfolios of managers. Alpha forecasts
one can derive a formula for building an alpha made using this approach will be internally con-
forecast out of seven elemental parts: sistent, clearly communicable and defensible.
Additionally, robust alpha forecasts are required
1. The sponsor’s forecast of the manager’s skill
for manager-structure optimization. Optimized
relative to peers.
portfolios of managers will differentially weight
2. The sponsor’s self-assessment of his ability those managers that have the highest alphas and
at selecting good managers. the lowest active risks, a result which almost never
happens from intuition-driven weighting schemes.
3. The variation (distribution) of manager skill
across the manager peer group.

2 InvestmentInsights

w Forecasting is really hard, especially

when it is about the future.

e expect the premise of this article—that one can and should fore-
cast manager alphas—to be challenging for many readers. In our experience,
many investment professionals simply do not believe that fund manager alphas
can be meaningfully forecast. There is some irony in this reaction: Our observation
includes many, if not most, of those people whose actual daily work is dominated
by the task of selecting and monitoring active fund managers.
—Attributed to Niels Bohr 1

Selecting active fund managers and building portfolios the sponsor as it is for the fund manager: to maximize
of them is an exercise in active management com- expected portfolio alpha (net of fees) at an acceptable
pletely parallel to the work of conventional active fund level of active risk.2 And some forecast of future per-
managers in selecting securities. The only difference formance seems essential to either task.
is that the securities selected are not “atomic” securities
As its point of departure, this article relies heavily
(the individual securities out of which fund managers
on Waring, Whitney, Pirone, and Castille (2000)
build their portfolios) but “molecular” securities, the
and Waring and Siegel (2003). These articles discuss
portfolios themselves, which are built up from many
methods for building portfolios of active fund man-
atoms. And when a sponsor builds a portfolio composed
agers. The Waring and Siegel article, in particular,
of these molecular securities, the usual prescriptions
promised further improvements in these forecasting
for active portfolio construction still apply. The objec-
methods. It is that promise that we mean to honor here.
tive function for portfolio optimization is the same for

1  araphrased from, accessed on October 11, 2007. The origin of this quote is not precisely
known. It has also been attributed to the Danish-American comedian and pianist Victor Borge.

2  e use the term “sponsor” throughout, but we mean the article to fully and generally apply to all investors—plan
sponsors, foundations, endowments, individual investors, and anyone else facing the task of evaluating professional
investment fund managers.

june 2008 3
Why forecast alphas? not require any decision other than whether to hire or
Although many sponsors try mightily to avoid making not hire the fund manager who appears to be “best” in
specific forecasts of manager alphas, we would point out a beauty contest parade of applicants—which is today’s
that the sponsor’s holdings of active managers already dominant method of selection. Someone with such a
contain embedded forecasts of the alpha for each man- mind-set might naturally wish to avoid claiming much
ager. One simply needs a specially fitted optimizer—a credit for success or being held accountable for failure,
“reverse optimizer”—to tease the alpha forecasts out.3 and the beauty contest process supports such an aspira-
Such an optimizer assumes that the sponsor thinks of its tion admirably! We could posit other explanations for
portfolio of managers as optimal, which in the context of current practice, but the conclusion is the same: Practical
active manager selection means that the sponsor portfo- results could be much improved by either (1) carefully
lio must maximize the expected overall portfolio alpha at applying skill to the task of making alpha forecasts or
a given level of overall portfolio active risk. The reverse (2) giving up on the use of active management and
optimizer backs out the alpha forecasts that would be defaulting entirely to inexpensive index funds.
required for the portfolio of managers to be optimal. We
As we will see, one can, in fact, build portfolios of securi-
have conducted this exercise with many sponsors’ port-
ties and hire active fund managers successfully—that is,
folios, and we are often surprised by the huge expected
with an ex ante expectation of a positive expected alpha—
alphas that are implied by the large holdings of some
given certain conditions. The finance professors who taught
of their active managers (and particularly by the large
us that “you can’t beat the market” were only correct as
holdings of those managers who take a lot of active risk).
far as they went. Let’s go further.
But our main point is not that the implied alpha forecasts
are sometimes impossibly large; our point is that they
are there. One cannot build a portfolio of active managers The Two Conditions for Success
without making alpha forecasts for each manager, either in Active Fund Management
explicitly or implicitly. Doing so explicitly is much better. Few finance professors would assert today that markets
Explicit alpha forecasts can give the sponsor more mean- are perfectly efficient. Most of them (as well as most prac-
ingful guidance regarding which fund managers to hire, titioners) would agree that the markets generally approach
whether to fire or retain a manager, and how to weight efficiency without attaining it. It is in the imperfections—
the managers in the portfolio. And such forecasts are those bits of price-relevant information or knowledge that
essential to a well-optimized portfolio of fund managers. are not yet efficiently and fully impounded in prices—that
opportunities for above-market returns might be found.

Why Do Sponsors Resist Making But we must be careful here. Many investors express the
Explicit Alpha Forecasts? belief that one should always choose active fund managers
Reluctance to make alpha forecasts may reflect an underly- (instead of index funds) in any market that is inefficient.
ing skepticism that any fund managers are capable of But this belief is seriously in error. Some inefficiency
delivering positive alpha consistently. After all, profession- in the relevant market is a necessary condition for the
als in the sponsor organization would have been lectured expected success of active fund management, but it is
repeatedly during their formal finance education that “the not a sufficient condition: Even the most inefficient market
market is efficient” so “you can’t beat the market.” Perhaps imaginable—say, a “frontier” emerging market country—
the real reason they continue to hire active fund managers is still a zero-sum game, in which the returns of all active
is that their boards and committees expect them to, not players sum to the return of the market itself. (That is, an
because they believe doing so will add value. If the spon- index fund of that market will have mean performance,
sor’s board or committee expects the sponsor to hire and before fees and costs, with some active players beating it
retain active fund managers, but the sponsor secretly does and some losing to it.) More than inefficiency is required
not believe that managers can be successfully chosen for active management to beat an appropriate competing
ex ante, the sponsor might prefer a process that does index fund.

3 Specifically, what is needed is an active risk–active return optimizer that is capable of running in reverse. See Waring
and Siegel (2003).

4 InvestmentInsights
What more is required for predictable, rather than random, n Some degree of inefficiency in the relevant market, and
success? The fund manager must either know something n Above-average skill on the part of the fund manager.
that others in the market do not know, or understand
The first condition is easy for most people to accept.
more clearly something that is also known to others but
The second can be accepted as a general proposition
not as well understood by them. The active manager has
by most, in the sense that some managers must have
to have an edge over the other players in the market. For
above-average skill or the Warren Buffetts of the world
short, we call this edge “skill.”4 Formally, we refer to this
would have no honor. But it causes angst if we try to get
skill as a “positive information coefficient.”5 Formally,
specific: From a population of managers who obviously
the information coefficient is the correlation of a man-
do not have above-average skill on average, how can one
ager’s forecasts with subsequent realizations, and it is
identify which managers do have special skill?

So, it does not make sense to hire active fund managers

simply because they are active—ever. And hiring active fund
managers without making and using explicit expected alpha
forecasts for each of them is definitely suboptimal.

a forward-looking concept: A fund manager has a positive Let’s turn to the perspective of the hiring sponsor.
information coefficient if the manager can, more often
than not, predict which securities will have positive The Two Conditions for Employing
alphas (and what their magnitude will be) during the Active Fund Managers
upcoming period.6 What must a sponsor believe before deciding to hire
Such special skill is the ingredient for fund manager active fund managers—that is, if the sponsor wants to
success that is in limited supply and that is also difficult hire a portfolio of active fund managers having a collec-
for the sponsor to assess. Investors do not want to play tively positive expected alpha?
the great zero-sum game—choosing to actively manage First, the sponsor has to believe that successful active
a portfolio rather than passively hold its benchmark— management is, in the abstract, possible. Although tra-
unless they believe that they have skill at identifying ditionally this belief has been pooh-poohed (“you can’t
securities or other investment positions that will earn beat the market”), we hope we have been persuasive in
a positive alpha in the coming period. the prior section that this is, in fact, possible (and we
So, the Two Conditions required for a specific active fund argue for it in greater detail later). So, the sponsor must
manager to have a positive expected alpha are

4 Below-average managers also have some of what would ordinarily be called “skill,” but not enough to be valuable.
“Skill” in the specialized sense that we use it here is the ability to win a zero-sum game. It thus implies an ability
to add value, which is not ordinarily something required when the term is used in other contexts. A below-average
doctor, for example, is not only skillful but valuable; because he or she is not playing a zero-sum game, any
contribution is a plus. But a below-average active manager has negative economic value. See, for example,
Siegel (2004).

5 “Information coefficient” is the preferred term for skill in the literature of finance; see Grinold and Kahn (2000a,

6  fund manager who can predict which securities will have negative alphas and predict what their magnitude
will be also has skill (a positive information coefficient). This information is profitable if used as part of the
selling discipline of a long-only manager or for selling short if the fund manager is allowed to do so.

june 2008 5
accept the first set of the Two Conditions as expressed in number are going to get a C. The bell curve, or normal
the prior section, under which one can believe that good distribution, does a great job of lending intuition to the
fund managers might, in fact, exist. A more intuitive way notion that some of us are more skillful than others, and
to express this is that the sponsor must first believe that it is logical to assume that this distribution is a decent
some “good” fund managers do exist. descriptor of skill or talent in any endeavor—including
active management.
Second, the sponsor has to be able to move from the
general to the specific: It must believe that it has the skill What does it mean to have skill in active management?
to identify fund managers that have skill—that is, the Because the average player in the markets is fairly well
skill to differentiate between the good, the bad, and the educated and intelligent, the skill levels needed are those
indifferent fund manager, before the fact.7 So, the key that stand out in a tough crowd. To be considered skillful
to success for sponsors is also skill. in this particular sense requires more than merely being
smarter than the average human being or even being
Skill more skillful as an investor than the general population.
In short, two very separate levels of skill are required: To have an expectation of being a successful active man-
The sponsor needs to have skill at identifying fund ager, one must have skill that is above average relative to
managers who have skill at picking securities and the skill of others who are “playing the game” of trying
other investment positions. to beat the market. That is, one must be above average in
an above-average domain. If active management were a
Across the universe of players, skill averages to a value
zero-sum game, then perhaps half of those actually play-
of zero. The average investor gets the market return,
ing (that is, of those thinking themselves good enough to
which is a way of summarizing Sharpe’s wonderful 1991
give it a try) would have sufficient skill. But because it
article, “The Arithmetic of Active Management,” in which
is a negative-sum game, only something less than half of
he so eloquently showed that the market is a zero-sum
the players will be skilled enough to win after covering
game. More completely, the market is a negative-sum
their fees and embedded costs (and to win by enough to
game, with the negativity reflecting the necessary impact
justify the additional risk taken on).8
of fees and costs incurred in the effort of playing the game.
The good news for sponsors that plan to hire active man-
But not everybody is average! In fact, in nearly any skill-
agers, however, is that skill levels do, in fact, vary widely.
based activity, whether it is buying stocks or figure skating,
The market is a mechanism by which the more skilled can
there is a wide distribution of skill levels among the
profit at the expense of the less skilled. So, good players
population engaged in the activity. Most of us have
almost certainly must exist, both at the fund manager level
recognized, ever since some junior high school teacher
and at the sponsor level. A sponsor with skill at identifying
explained she was grading “on the curve,” that some few
fund manager skill has a serious edge.
are destined to earn an A and equally few will earn an
F, that more will earn a B or a D, and that the greatest

7 The sponsor’s skill includes the collective skill of the board, staff, and any consultants or other advisers used in the
fund manager selection process. Real skill may exist but be diluted in practice by the governance and decision-making
structure. A sensible effort to reduce that dilution might include a board decision to turn the skill-based decisions over
to professionals on their staffs selected for that skill.

8 I n light of the daunting odds of the game, the reader might wonder why so many active manager mandates are still
granted by plan sponsors. One answer is the pervasive human tendency toward overconfidence, which has been a
major topic among behavioral finance researchers. Much of the literature on overconfidence proceeds from the obser-
vation that trading volume is way too high to be explained by rational models (see, for example, Odean [1998, 1999];
Statman, Thorley, and Vorkink [2006]). Those who choose to index are admitting that they possess only average (or
worse) skill, and what plan sponsor is going to admit that?

6 InvestmentInsights
Comparing Techniques for alpha (summed across the managers) at a given or
Building Portfolios of Managers “acceptable” level of active risk (also taken collectively
Today’s most common manager selection approaches across the managers). To build such a portfolio, expected
almost never include an explicit alpha-forecasting pro- alpha must be specifically estimated for each candidate
cess. The widely used beauty pageant approach tries to fund manager. The method has become known as “man-
pick the “best” manager, but little or no effort is made to ager structure optimization.”10
quantify specific expectations for future alpha (unless one
Soon after those publications, Kahn (2000) showed that
gives credit to the effort to sort out future performance by
in an ideal optimized portfolio of managers, the ideal
studying past performance, a dangerous credit to extend).
manager weights, w*Mgr , would be proportional to the
Of course, there is a hope that the manager chosen will,
manager’s expected alpha,
at a minimum, outperform the appropriate benchmark.9
active variance, 2
aMgr , divided by expected
Mgr :
After all, staff members, committees, and boards do take q
their tasks seriously, and if the “best” manager from this
process were not even expected to outperform an index w*Mgr ~
aMgr . (1)
fund, then one supposes (or at least hopes) that the man- q Mgr
ager would not be chosen.
Equation 1 is algebraically equivalent to saying that the
Not only is the list of managers selected important, but
total “bet”—that is, the optimal manager weight times
so are the weights given to these managers. In today’s
the manager’s active risk—is proportional to the man-
practice, manager weights are often dictated by the desire
ager’s expected information ratio, IR:
to fill out “style boxes,” a method that assigns weights
based on the styles (i.e., multifactor beta characteristics)
aMgr = IR. (2)
of the fund managers. So, managers are selected in a
q Mgr ~
series of beauty contests, and then the portfolio is built qMgr
by investing in those managers in amounts sufficient to
fill out each style box’s required weight. The perspectives of Waring et al. and of Kahn show—and
for the same reason—that expected fund manager alpha
In contrast, Waring et al. (2000) provided a different
is one of the most important determinants of the ideal
method. The authors extended the active portfolio con-
weights of managers in the portfolio.
struction approach of Grinold and Kahn (2000a) up one
level—from the fund manager’s problem to the sponsor’s So, it does not make sense to hire active fund managers
problem. They showed that the ideal portfolio of managers simply because they are active—ever. And hiring active
is an optimized one that maximizes overall expected fund managers without making and using explicit expected
alpha forecasts for each of them is definitely suboptimal.

9 More precisely, the expectation is that the active manager will outperform an index fund managed to the same bench-
mark after adjustment for the difference in fees.

10 This method includes mechanisms for controlling “misfit risk.” Sponsors generally, and appropriately, impose an implied
constraint that the sum of all the sponsor’s multifactor beta exposures (asset classes and styles, usually), taken across
all the fund managers and other subportfolios, must equal the sponsor’s current target asset allocation policy (strategic
plus current tactical policy, if any). Misfit risk is the risk that comes from violations of this constraint—an overexposure
to value, for example. This constraint is important to sponsors, and to operate under it, fund managers are constrained,
in turn, to stay relatively close to their (disclosed) benchmarks. Market-neutral, long–short managers, whose forward-
looking benchmarks have zero multifactor beta weights, are also constrained to stay that way, at least on average over
time. Thus, the result of a manager structure optimization is an optimized improvement over the use of simple style
boxes, ensuring not only an optimal tradeoff of alpha for expected active risk, but also that the sponsor’s benchmark
is maintained.

june 2008 7
Moreover, not surprisingly, the expected alpha will The prescription is only slightly more helpful if the fund
also have an important impact on the weight given manager’s data do pass the t-test. If a 95% confidence
to each manager selected. Thus, optimal portfolios of interval is used, there is still at least a 5% chance—and
fund managers require specific estimates of expected in reality, it is much greater—that the strong performance
fund manager alpha. was simply a random occurrence rather than the result
of skill. As we said, getting information out of historical
Do Historical Alphas Help alpha data isn’t easy.
Forecast Future Alphas? The best conclusion is that passing the t-test provides only
The regulator’s required disclaimer to the effect that evidence of skill, not proof. Therefore, although the fact
“past performance is no guarantee of future performance” that a manager’s historical alphas have passed a t-test is
is correct, but it can be overgeneralized to mean that surely admissible (in the technical sense) in the process
historical data never contain any useful information. of evaluating fund managers, it is by no means conclusive
That interpretation is not true; but even so, with rare as to the manager’s skillfulness. The sponsor should also
exceptions, whatever information does happen to be look at fundamental data. So, whether the data pass a
in the data is extremely difficult to ferret out with t-test or not, historical data should be relied on much less
any confidence.11 than is found in current manager selection practices.
One method of extracting information from the data might Here is another way to look at the historical data issue:
be to use a statistician’s tools for separating skillful from If real information in the historical data is so difficult to
unskillful historical performance. A difference-of-means tease out that a sponsor is not going to be successful in
test (which provides the familiar t-statistic) could be used the effort, then any portfolio of fund managers constructed
in an attempt to reject the null hypothesis that the histor- by the sponsor on the basis of those data is simply going to
ical alpha of the fund manager has a zero mean (before have random performance around the benchmark—that
fees). Few managers’ data sets will “pass” such a skill is, zero mean alpha before fees and costs, and negative
test, however, because by construction, passing generally mean alpha after fund manager fees and costs. A port-
requires something like a 95% confidence level.12 folio based on such data, without skill, is a “closet index
This situation is a real challenge to the widespread prac- fund”—and one with high fees and high tracking error.
tice of giving heavy weight to historical fund manager It will deliver its beta, but it will only outperform or
alpha. If one cannot claim with reasonable certainty that underperform randomly; its realized alpha over time
the fund manager’s mean historical alpha is significantly will simply be Brownian motion—pure randomness
different from zero—if it does not pass the t-test—the with a negative bias.
statistician has a strict prescription for these sponsors: Such a portfolio, and sadly it is the norm, creates the
Simply throw the historical data away and completely expectation that the efforts of the sponsor will result
disregard them when considering the manager’s future in true added value. But, in fact, it confuses motion
alpha. Only other data, most likely fundamental data, with forward progress. A sponsor using historical data
can be fairly considered in this event. to project future alpha could reduce its active risk and
improve after-fee performance simply by moving to an
all-indexed implementation.

11 Numerous studies have examined the persistence of mutual fund performance; see Grinold and Kahn (2000a) for a
survey. Although the findings have been mixed, because of differences in study period, time horizon, and methodology,
the correlation between past and future performance generally appears to be fairly low. Even optimistic studies indicate
that the probability of a past winner remaining a winner is only about 60%.

12 The probability levels actually used as boundaries for passing such a test (or, more properly, for rejecting the null
hypothesis) depend on both the specific type of test and, to some extent, the judgment of the statistician establishing
the confidence boundaries to be used.

8 InvestmentInsights
portfolio’s expected alpha,
In contrast, if the portfolio of fund managers is assembled
optimally, with skillful (after-fee) alpha forecasts that active risk,
a, to the portfolio’s pure
. According to the fundamental law, the
do not rely inappropriately on uninformative historical expected information ratio is a function of the information
(or other) data, it will have a positive expected alpha coefficient, IC, and of selection breadth, Br. In mathematical
at the total portfolio level, a characteristic that index notation (with the expectations operators omitted from
funds obviously cannot have. Such an outcome can be the variables to simplify the display), the law is
achieved only by a sponsor that has and uses skill in
identifying fund manager skill. There is no formula; IRMgr| Mgr =

there is no recipe; there are no shortcuts.
q Mgr
Skill necessarily implies the exercise of informed judg- = ICMgr| Mgr BrMgr| Mgr . (3)
ment. So, at some point, someone must make a claim of
skill and be prepared to try to deliver on that claim. This
We have used a separator in the subscript notation, as
person, or group of persons, needs to step up to the plate,
in ICMgr|Mgr , to help us keep track of, first, which player
make an informed but judgment-based forecast for the
it is (the fund manager or the sponsor) that the estimate
alphas of the candidate fund managers, and be account-
applies to and, second, which player is making the estimate
able at the total portfolio level for being more right than
or is responsible for the result. This example, ICMgr|Mgr ,
wrong. We now present a methodology for sensibly
means “the information coefficient of the manager in
approaching this task.
the view of the manager” (a self-assessed information
coefficient). If it were ICMgr|Spon , it would mean “the
information coefficient of the manager in the view of
Forecasting fund the sponsor” and clearly could differ from ICMgr|Mgr .
manager alphas Ditto for other variations.
Two useful relationships are described in the active man-
agement literature that can be used to guide the search In plain language, then, Equation 3 reads: “The expected
for a method of forecasting alphas. The first is the fun- information ratio of a fund manager’s active portfolio, in
damental law of active management, which we shorten the view of the manager, equals the expected informa-
to the “fundamental law.” The second is often called the tion coefficient, or skill, of the manager (as assessed by
“forecasting equation.” Both are attributed to Grinold the manager) times the square root of expected breadth
(1989, 1994).13 of the portfolio.”

Not surprisingly, both of these relationships are closely In Equation 3, the information coefficient represents the
tied to skill, and given the two levels of skill required fund manager’s skill at forecasting the returns of the
in our problem, we’ll find this to be useful. We’ll review individual securities that may go into his or her portfolio.
these relationships in the context of this paper’s task It is more formally defined as the expected correlation
and then look at how to use them, or variations of them, coefficient between forecast returns and subsequent
to formally forecast fund manager alpha. realized returns.

Breadth, Br, represents the number of independent

Relationship No. 1: (uncorrelated) bets that the fund manager makes in the
The Fundamental Law measurement period—usually a year. It is a measure of
The fundamental law is most often stated in a form that the extent to which active bets are diversified or, more
shows the relationship of a fund manager’s expected precisely, the extent to which forecasting skill is applied
portfolio information ratio to certain of its key determi- broadly among securities (or other investment positions).
nants. The expected information ratio is the ratio of the

13 Both relationships are also developed in Grinold and Kahn (2000a).

june 2008 9
The breadth term in the fundamental law implies that the Relationship No. 2:
most consistently successful fund managers are those The Forecasting Equation
who apply their forecasting skill widely over a large The forecasting equation is
number of independent bets. As Grinold and Kahn noted, (6)
the fundamental law boils down to a mandate to “play
aSec|Mgr = ICMgr|Mgr q Sec|Mgr zSec|Mgr .
often, and play well.”14 Equation 6 means that the expected alpha of a security in
the view of a portfolio manager is the product of the skill
Although the original fundamental law was derived
of the manager, times the active risk (standard deviation
in the absence of constraints, real-world portfolios are
of residuals) of the security, times the z-score of the
rarely unconstrained. Grinold and Kahn (2000a) dem-
security—all as assessed by the manager. Grinold’s
onstrated that the long-only constraint severely limits
purpose in developing this relationship was to help fund
fund managers’ abilities to implement their insights and
managers readily form forecasts of alpha for individual
results in a significant performance drag when such
securities (not alphas for the fund manager portfolios
portfolios are compared with a similarly optimized but
themselves, consisting of many securities).
unconstrained portfolio. Thus, the fundamental law can
be expanded to include an additional term, referred to as The z-score is a standardized variable that reflects the
the “transfer coefficient,” that reflects the performance fund manager’s evaluation of the “goodness” of a security
drag or inefficiency resulting from constraints.15 Stated (or in the application we describe next, the sponsor’s
another way, the transfer coefficient is the ratio of the evaluation of the extent of the fund manager’s skill).
information ratio of the portfolio to the information ratio Mathematically, the z-score has a normal distribution
of a portfolio based on identical information but imple- with a mean of 0 and a standard deviation of 1. Thus,
mented without any constraints. “buys” would be assigned a positive z-score and “sells”
a negative z-score. A z-score of 1, for example, suggests
So, the fundamental law, modified to incorporate the
that the security is believed to be 1 standard deviation
transfer coefficient, TC, and subscripted to apply to
better than average; it would thus be better than roughly
its ordinary perspective, that of the fund manager, is
five-sixths of all stocks being assessed by that fund man-
ager. Rarely would a security earn a z-score of 2, and a 3
IRMgr| Mgr =
aMgr|Mgr would be a one-in-a-thousand event. If a fund manager
q Mgr|Mgr (4) had no view on a security, the manager would assign it
a 0 z-score, implying no alpha expectation.
= ICMgr|Mgr BrMgr|Mgr TCMgr|Mgr . (4)
The security’s residual or pure active risk ( Sec|Mgr ) is
the standard deviation of the security’s monthly or annual
We are interested in forecasting alphas, so we restate the
alphas over time. The more volatile the security’s alpha,
fundamental law to focus on the expected alpha term by
the greater the opportunity to profit from its price moves—
multiplying both sides of Equation 4 by expected active
for example, by buying it on its upswing and selling it on
risk (moving to the right side of the equation):
q its downswing. Thus, a higher volatility translates into a
higher expected alpha, for a given level of skill.
Mgr|Mgr = ICMgr|Mgr Br Mgr |Mgr TCMgr|Mgr Mgr|Mgr . (5)
a q This forecasting formula is Bayesian, in essence. It begins
with a raw forecast—that the security alpha is the product
So far, the point of view has been that of the manager,
of the standard deviation times the z-score assigned to
but the sponsor has not been forgotten. We will come
the security by the manager—thus, for the moment,
back to the sponsor’s role in a moment.

14 In this context, by “play often,” Grinold and Kahn (2000a, p. 162) mean that the skillful investment manager should make
many specific, small, and unrelated bets—not that the manager should simply incur high turnover by betting frequently.

15 Clarke, de Silva, and Thorley (2002) developed this important generalization of efficiency.

10 InvestmentInsights
treating this result as if it were a perfect forecast. The requires a self-assessment of the sponsor’s skill at this
formula then modifies this raw forecast, correcting it task. To do this, we tie together a new form of the fore-
back toward the null hypothesis (or “prior”) that the casting equation with a form of the fundamental law to
unconditional forecast is zero by multiplying it by the complete the description of the fund manager’s expected
skill term—the manager’s own information coefficient. alpha at the level of the manager’s total portfolio.17

Adapted to apply to the sponsor’s skill at assessing fund

The “Alpha-Builder”
manager skill, the forecasting equation looks like this
Forecasting Framework (see Appendix):
We now have the building blocks for a very complete
forecasting framework and can tie them together. A prior ICMgr|Spon = ICSpon|Spon (8)
article (Waring and Siegel 2003) provided a preliminary
jICMgr|Spon zMgr|Spon .
approach to forecasting alpha consisting simply of the
Equation 8 means that the expected information coeffi-
Grinold forecasting equation with minor adjustments to
cient of a fund manager in the view of the sponsor is the
adapt it to the problem of sponsors assessing the expected
product of the sponsor’s (self-assessed) skill at manager
alpha of managers:
evaluation, the standard deviation (cross-sectional) of
= ICSpon|Spon Mgr|Spon zMgr|Spon (7)
aMgr|Spon –Fees q fund manager information coefficients, and the z-score
Mgr . of the particular fund manager’s information coefficient

(in the view of the sponsor). This relationship explicitly
Equation 7 reads: “Expected alpha for a fund manager, incorporates both the sponsor’s skill level in assessing
in the view of the sponsor, is equal to the sponsor’s skill fund manager skill and the fund manager’s skill.
times the fund manager’s expected level of active risk,
Combining the two relationships, we substitute the spon-
times the unit normal z-score, zMgr|Spon , assigned
the fund manager by the sponsor as an expression
sor’s estimate of the manager’s information coefficient,
ICMgr|Spon , from Equation 8 in place of the fund manager’s
of the sponsor’s view of that fund manager’s skill level,
self-estimated information coefficient, ICMgr|Mgr , into the
minus fees.”
fundamental law, Equation 5. This transfers the respon-
In practice, this forecasting equation seemed to produce sibility for the resulting estimate of the fund manager’s
reasonable results when used with the technology for alpha to the sponsor:
optimizing fund manager structure and budgeting fund
manager risk described earlier. Yet, we were convinced aMgr|Spon = ICMgr|Spon BrMgr|Spon
that it could be improved. For one thing, this formula Spon’s view (9)
of Mgr’s IC
clearly does not explicitly incorporate the two levels of
x TCMgr|Spon
required skill. For another thing, it does not incorporate q Mgr|Spon .
other known important variables, such as fund manager Writing Equation 9 out in full by using the righthand
breadth and the transfer coefficient. We anticipated fur- side of Equation 8, we get
ther developments; this article is the result.16

The first major improvement is that we directly evaluate

aMgr|Spon = ICSpon|Spon jIC zMgr|Spon
the fund manager’s forecasting skill, the information
Mgr|Spon (
Mgr|Spon IC (10)
coefficient, rather than the manager’s alpha as we did in
x BrMgr|Spon TCMgr|Spon Mgr|Spon .
the prior effort. And second, we make it so that whenever
a sponsor assesses fund manager skill, the methodology

16 See Waring and Siegel (2003, Note 25).

17 The authors’ colleague and friend Ronald Kahn suggested this particular way to combine the two forecasting
equations, thereby cleverly and insightfully solving a problem that we had been working on for some time.

june 2008 11
Equation 10 has the happy benefit of reflecting the need The average z-score, taken across the universe of all
to quantify the sponsor’s skill at assessing manager market players, must be zero. The framework assumes
skill as well as incorporating both the breadth and the that fund manager skill, as with most other human skills,
transfer coefficient terms—all improvements to the first is distributed approximately normally but (unlike most
forecasting effort of Equation 7. human skills) with a mean of zero.18 Of course, assigning
a z-score of zero (for our average fund manager) would
Finally, parallel to the earlier effort, we subtract fees:
result in an estimate that this fund manager’s expected
= IC Spon|Spon zMgr|Spon
a Mgr|Spon j IC
alpha is zero, less fees, which is consistent with a prior
belief that only the above-average fund manager can
x BrMgr|Spon TCMgr|Spon (11)
q Mgr|Spon be expected, before the fact, to succeed in the active
– FeesMgr|Spon . management game.

By moving beyond the averages and focusing on the
Equation 11 is our model of expected fund manager
individuals, however, sponsors can conceivably design
alpha in a complete form. This approach, which we
a set of criteria to assist in assigning z-scores, a kind of
refer to casually as the “Alpha-Builder,” involves seven
“fundamental analysis” approach to manager selection.
input variables, and all but two of them are relatively
A fund manager’s historical track record would no doubt
straightforward to estimate.
influence the assigned z-score, but other factors—such
as quality and perceived insight of the research team,
The Input Variables compensation structures, rigor of analytical processes,
We can provide some guidance in estimating values for
and generosity of research budgets—would be impor-
all seven input variables, although the fund manager’s
tant to most thoughtful sponsors. This area is fertile for
z-score and the sponsor’s own information coefficient
research by sponsors and fund-of-funds managers. Just
will always be the values that are most challenging.
as fund managers conduct research on factors that
Fund manager z-score (zMgr|Spon ). Fund manager predict security returns, successful sponsors will focus
z-scores are the most important input for forecasting on identifying factors that predict fund manager skill.
expected alpha, but at the same time, among the hardest
We see many sponsors attempt to reduce their selection
to assess. All but one of the other inputs are capable of
efforts to a repeatable process or “recipe.” An estimate of
being estimated via direct quantitative approaches, but
expected alpha, explicit or implicit, is likely to be worth-
the fund manager z-score usually depends on factors that
less, however, if it can be reduced to a recipe. That is, skill
are hard to quantify. They should be hard to judge, because
and judgment have to be in the mix somewhere, and the
the z-score is where the sponsor’s skill level is tested—if
use of a recipe inherently suggests that one is avoiding
assessing z-scores were easy, everybody could do it! And
the use of skill or judgment.19
if everybody could do it, there would be no alpha. Manager
z-scores are inherently subjective and require the sponsor
to exercise skillful and informed judgment.

18 One might argue that the mean is not zero for professional fund managers, but possibly positive as a result of a
categorical difference in skill between individual investors and professionals. Waring and Siegel (2003) suggested,
however, that if there is such a group effect, it is small, at least in the US, perhaps only 50 bps or so—not enough to
offset fees. Regardless of the argument, if an analyst thinks that the true mean for the relevant group of professional
fund managers is different from zero, the analyst should simply add the difference to the results from the framework.

19 The exception might be for effects that have not yet been generally discovered and that remain unincorporated in prices.
Many modern portfolio researchers look for such effects. Certain of these researchers may reduce their ideas to com-
puter code (i.e., recipes) in apparent violation of the prescription in the main text. However, the required judgment is
being exercised when the effect is chosen as a “signal” for the portfolio construction process, and each time the signal
is reviewed for continued inclusion. Moreover, over time, most such effects do become known, so the next opportunity
to exercise skill is deciding when to remove a given signal from the overall model. Most commonly repeated recipes
involve well-known ideas and are unlikely to be successful except by chance.

12 InvestmentInsights
Table 1 fund manager with an S&P 500 Index benchmark at an
relationship between fund manager active risk level of 5.0%, which is typical of a traditional
z-score and percentile rank
active manager who is at the first quartile of perfor-
Percentile rank Manager z-score mance.20 ) Obviously, there is some room to hope for
improvement in this estimate, particularly when dealing
2 –2.0
with managers of asset classes other than large-cap US
7 –1.5
equities. Until better data are available, however, we
16 –1.0 will use the 0.07 estimate for most benchmarks.
31 –0.5
Sponsor skill (IC Spon|Spon ) . This variable may be the
50 0.0
most difficult to assess of the seven in the model; it is
69 0.5
certainly one of the two most difficult to estimate (the
84 1.0 other being the z-score). IC Spon | Spon , the information
93 1.5 coefficient of the sponsor, in the sponsor’s own view,
98 2.0 is a quantification of the sponsor’s skill in picking good
active fund managers—or, more precisely, of the sponsor’s
skill in assessing the fund managers’ skill. IC Spon|Spon = 0
We have found percentiles to be more intuitive for many implies a before-fee expected alpha of zero, regardless
sponsors than raw z-scores when evaluating fund manag- of how high a z-score the sponsor may have given a
ers. Because z-scores are inherently normally distributed, particular fund manager: It means that the sponsor itself
a percentile rank can be easily translated into a z-score believes that its estimate of the manager’s z-score is no
by using standard probability tables. Table 1 indicates good and should not be used (so it will not be used because
that a fund manager thought by the sponsor to be at multiplying by IC Spon|Spon = 0 yields a before-fee expected
the 84th percentile can be understood by the analyst to alpha of zero, no matter what the other inputs are). In
have an assigned z-score of +1, whereas a fund manager other words, no matter how good the sponsor thinks a fund
assigned a 98th percentile rank can be interpreted as manager is, if the sponsor’s judgments are not believed—
having a z-score of +2. even by the sponsor—to have any predictive ability, they
are irrelevant and the sponsor should not expect any alpha.
Variability of fund manager skill (jICMgr|Spon
) . This
variable represents the cross-sectional standard deviation Estimating sponsor skill is a problem in self-assessment.
of skill (where skill is expressed as the information coef- It is difficult to do in any completely satisfactory manner
ficient) across the universe of generally similar active because the board, staff, and consultants involved in the
fund managers. Intuitively, one can understand that the process rarely have the data needed to demonstrate their
greater the variations in fund manager skill, the greater own statistically significant performance. In fact, the
the impact of sponsor skill in selecting a good manager— more completely they understand the problem, the more
thus, the greater the sponsor’s alpha expectations (even modest they may be in claiming special skill. But these
after being pared back by the action of the other terms people may be precisely the ones who have the greatest
of the forecasting approach). chance of winning the game.

There is no direct way to observe this standard deviation, We are not going to tell anyone how to estimate his or
but one can back into it inferentially. We believe that her own skill, but we would start by noting that if a
an estimate of 0.07 for is sensible, and we note given sponsor is playing the active manager selection
that this value is consistent with large-capitalization US game, then it has also made an implied positive estimate
equity mutual fund data; we are currently using it and of its skill, IC Spon|Spon . The game leaves the sponsor no
have found that it gives reasonable estimates. (As shown room to be troubled by its inability to be certain about
in the first examples in the next section, this value pro- its own skill. The zero-sum game of active management
duces an information ratio of 0.50 for an active equity requires that one believe in oneself. Everyone and every

20 By “at the first quartile,” we mean at the break point between the top 25% of managers and the next 25%.

june 2008 13
group that has ever considered engaging in a sporting Win rates (which we will designate p, the probability of
event or other contest has faced the same uncertainty success) range from 0% to 100%; information coefficients,
in what are also usually zero-sum games, yet the games being correlation coefficients, range from –1 to +1. We
are never short of players. The zero-sum game of active can convert the win rates to the information coefficients
management, as for most other games, requires only that by using the following:
one believe in oneself if one is going to play, and this is
IC Spon|Spon " 2 p –1. (12)
expressed as a positive IC.
Thus, if the sponsor anticipates being right 67% of the
Rather than estimate sponsor skill directly, some might
time, IC Spon|Spon is fairly approximated as 0.34; if the win
prefer to use a boundary condition to substitute for it. For
rate is 50%, then, of course, IC Spon | Spon is 0.00. Table 2
example, a sponsor might say, “We estimate that in order
lays out this relationship. In the next section, we examine
to have a portfolio expected alpha that is positive and
the impact of various information coefficients.
valuable, after paying fund manager fees and experienc-
ing active fund management transaction costs, we need
an information coefficient of at least 0.33.”21 Table 2
estimating sponsor skill
Such a boundary is not in itself a proper estimate of
sponsor skill—far from it—but it represents a lower Sponsor success Sponsor skill
proportion (p) (ICSpon | Spon )
limit on the amount of skill a sponsor must have, given
the prior intent to hire active managers, in order to be 0% –1.0

successful. The sponsor may well decide that its skill 20 –0.6
level is higher than the minimum level required to make 40 –0.2
the hiring of active managers a rational choice. But if 60 0.2
the lower bound itself is used by the staff as its estimate 80 0.6
of IC Spon|Spon , using the Alpha-Builder process will have
100 1.0
the virtue of organizing fund manager expected alpha
estimates in a form that is consistent from one manager
to the next, putting them on a playing field leveled for Any degree of error introduced by misestimating the
costs, risks, breadth, and the transfer coefficient. Using sponsor’s information coefficient will, of course, affect
the lower bound is a start, from which one can proceed the results. An obvious example is that a sponsor mis-
to more sophisticated estimates if one chooses.22 takenly claiming an information coefficient of 0.30 but
Many sponsors will prefer to express their self-estimate having a true information coefficient of 0.00 will achieve
of skill as an expected future “win rate” rather than an a return that is randomly distributed around the bench-
information coefficient. For example, a sponsor might mark with a mean of zero, minus fees and costs.
say, “I think about two out of every three fund managers Furthermore, low sponsor information coefficients favor
that we pick, or 67%, will outperform.” This estimate can low-fee and low-tracking-error managers. As the sponsor’s
be used to approximate the information coefficient.23 own information coefficient approaches zero, the net

21 There is nothing special about this number; we are using it simply as an example. But given typical values for the
other inputs in Equation 11, it is in the right range.

22 In fact, if the sponsor truly has the skill that the board’s decision to be active presumes, this manner of backing into
an estimate of IC Spon|Spon will improve the sponsor’s results. And if the sponsor does not have skill, then the portfolio
will be no worse off in expectation than it would be in the absence of the estimate.

23 Note that the expected win rate only approximates sponsor skill. Consider two sponsors with the identical expected
win rate: Of the two, the one that overweights the best of its good managers clearly has more skill than the one that
assigns them all equal weights (the sponsor gets value from estimating not only the sign of the manager’s perfor-
mance but also the magnitude). Regardless, using the expected win rate should provide estimates of the information
coefficient that are in the right ballpark.

14 InvestmentInsights
expected alpha for the manager derived in our frame- because the sponsor lacks access to full information
work will begin to approach manager fees.24 In this case, about the portfolio’s construction and the reasoning
any optimizer will simply pick the managers with the behind it.) Few forecasts are completely independent,
lowest fees and lowest active risk—that is, index funds. and many (or most) are highly correlated. An active fund
This result should not be a surprise. A sponsor with no manager benchmarked to the S&P 500 might hold all
confidence in its ability to pick managers shouldn’t 500 stocks in her portfolio and might turn the portfolio
really be investing in active managers. over 200% per year, which would imply that she has
made 1,000 independent decisions. But breadth for this
Anyway, if a sponsor is going to play the great zero-
manager could easily be much less than 1,000 if the fore-
sum game of active manager selection, and play to win,
casts were driven by certain common factors and, there-
the sponsor must take responsibility for the critically
fore, are correlated—as is likely to be the case most of
important self-assessment embodied in its estimate of
the time. For example, fund managers may assign higher
IC Spon|Spon . Without doing so, and coming up positive,
expected alphas to stocks that have done well recently
a sponsor simply cannot justify hiring active managers.

Sponsors need to proactively forecast alpha to

ensure that their portfolios of fund managers are not
merely random collections of past winners and losers.

Fund manager breadth (Br Mgr|Spon ) . Breadth is the (a momentum factor) or stocks in the technology industry
number of statistically independent investment bets (an industry factor). In these examples, the fund manager
made by an active manager each year. Greater breadth is essentially making only one informed bet (on momen-
results in more diversification of the residual risk from tum or on an industry) despite appearing to follow all the
the active management effort and, all else being equal, stocks in the benchmark.
improves the consistency (reduces the standard devia-
Nonetheless, a safe point for the sponsor to start the
tion) of the fund manager’s performance. If that fund
estimation process is to assume that most fund manag-
manager has skill, such that his expected alpha is a
ers’ breadth is proportional to the product of the number
positive number, then as the standard deviation of the
of securities being actively evaluated times the annual
residual risk decreases, the percentage of the time
turnover.25 But because of the number of signals used
that the fund manager’s realized alpha is above zero
and their correlation, as discussed, this proportion is likely
increases. In the same way, the house in Las Vegas
to be considerably less than 1. And the sponsor should
operating a roulette wheel, with its tiny built-in house
certainly refine any such rough estimate by using any
advantage, is almost completely safe if it handles a mil-
information it can obtain regarding the fund manager’s
lion bets for a dollar each, but is taking an unacceptably
signals and portfolio construction techniques. The goal
high risk by handling one bet for $1 million.
is to meaningfully differentiate the fund managers from
Despite the simplicity of the concept, estimating breadth each other based on what they actually do.
in practice is not an exercise in precision, whether the
The transfer coefficient (TC Mgr|Spon ) . The transfer
estimate is being made by the manager or the sponsor.
coefficient, as already noted, reflects the impact of con-
(The sponsor has even more difficulty than the fund
straints on the portfolio’s performance. The most binding
manager in accurately estimating the manager’s breadth

24 F
 ees are the only component of alpha that one can know for certain, and the fee amount does not require any estimate
of sponsor skill.

25 The
 term “actively evaluated” keeps the emphasis on the number of securities that the manager follows and could
potentially hold rather than on the number of securities currently in the portfolio. The number in the portfolio might
underestimate breadth because a manager might omit a security from the portfolio simply to reflect a negative view.

june 2008 15
constraint on typical portfolios is the no-shorting restriction. because portfolios with higher active risks are also
It severely limits a fund manager’s ability to implement penalized by having lower transfer coefficients.)
negative views on securities and reduces the alpha
Active risk is perhaps the easiest variable to forecast. It
potential of the portfolio.
is much more stable than alpha and can be reasonably
We can estimate the transfer coefficient of long-only equity estimated from historical data (usually with an acceptable
portfolios by using an empirical result presented in Grinold degree of error, but there are exceptions). At the same
and Kahn (2000b). They conducted simulations to exam- time, the sponsor must be sure that the active risk it
ine the information ratios of optimal portfolios based on measures is estimated relative to the appropriate bench-
the same information but implemented with and without mark, or beta (or, usually, a mix of multifactor betas),
the long-only constraint. They measured the transfer one that represents the fund manager’s opportunity
coefficient related to the long-only constraint, denoted set and process.
TCLongOnly , at varying risk budgets and for various bench-
Many active fund managers have systematic style biases
marks, and they found that their results fit the following
(value, small cap, etc.) that differ from their stated bench-
polynomial expression well:
marks. A simple style analysis can identify the fund
1– g (N)
qMgr ) –1 manager’s actual average style during the study period,
TCLongOnly = , (13) and active risk should be measured relative to this bench-
q Mgr 1– g (N)
mark if it has been relatively stable. Doing so provides
for a clean separation of the beta and the alpha exposures
where g (N) = (53 + N)0.57 (it is simply a calibrating factor
and ensures that the sponsor is focusing on the “pure”
that they estimated empirically) and N is the number of
alpha and pure active risk (Waring and Siegel 2003).26
securities in the benchmark portfolio.
Fees (Fees Mgr|Spon ) . Ultimately, returns net of fees rep-
Equation 13 demonstrates that the two factors that act
resent the true value added by the fund manager, so the
to reduce the transfer coefficient most in a long-only
sponsor should measure and account for fund manager
portfolio are (1) a larger number of stocks in the bench-
fees somewhere in the process. Even a fund manager
mark (which reduces the average weight of the stocks
with skill will add no value to the sponsor if his fees are
and thus the amount by which the manager can express
equal to or higher than his expected alpha. For this rea-
a negative view by not holding a stock) and (2) greater
son, note that zMgr|Spon is evaluated on a before-fee basis
active risk in the portfolio (which increases the size of
in our formulation; fees are then subtracted explicitly
optimal active positions, which are then increasingly
by using a separate fee term.
constrained if negative). The most “efficient” funds,
then—those with the highest transfer coefficients—
will be those with low active risks that are operating
in fairly narrow markets.
To demonstrate the alpha-forecasting framework, we first
Active risk (
q Mgr|Spon ). The fund manager’s active risk,
or tracking error, represents the annualized standard
consider examples that illustrate the importance of sponsor
skill by comparing the alpha expectations for sponsors
deviation of the fund manager’s residuals, or alphas. If a with varying abilities in picking good fund managers.
positive value is assumed for manager skill, higher active Then, we consider examples that explore the effects
risk translates into a higher expected alpha. (The rela- of the transfer coefficient and of breadth.
tionship is not linear, however, for long-only portfolios,

26 Carrying out some sort of style analysis on fund managers will generally be better than using a simple benchmark
when separating alpha from beta. The biggest exception is for style rotators, tactical asset allocators, and those whose
styles are themselves the subject of intentional active bets and thus not stable over time. In such cases, style analysis
may not effectively add to one’s knowledge of the fund manager’s beta. Regression is not powerful enough in the pres-
ence of time-varying beta bets. Other means, usually subjective, must be used.

16 InvestmentInsights
Impact of Sponsor Skill Unfortunately most sponsors do not possess such
We start with a simple demonstration of the impact of remarkable forecasting abilities. In Case 2A, we consider
sponsor skill on alpha expectations. In these cases, a a sponsor with much lower, but still positive, skill,
sponsor has identified a long-only active fund manager a humble IC Spon|Spon = 0.10. This sponsor also thinks
benchmarked to the S&P 500 with 5.0% tracking error. the same fund manager is borderline top quartile and
The sponsor’s staff and consultant are impressed with assigns the same z-score of 0.67, as was assigned in
the fund manager’s thoughtfulness, training, insight, Case 1. So, with all inputs other than the information
and other characteristics (probably including past per- coefficient left unchanged, the estimated manager skill
formance!). The sponsor assigns the fund manager a is far lower than in Case 1 and, therefore, the expected
z-score of 0.67, a value indicating exactly borderline top- alpha is also far lower, at 0.24%. This sponsor knows
quartile skill (this figure is directly from the cumulative that it will often be wrong in its evaluation of fund
normal distribution table). Table 3 shows the evaluation manager skill (45% of the time, from Equation 12) and
of expected alpha from this manager in four sponsor sce- will thus hire many fund managers who turn out to be
narios, which vary as to the sponsor’s self-assessment duds. Thus, the sponsor’s overall realized alpha will,
of its own skill at assessing fund manager skill and in in fact, be lower, and its expectations should also be
the level of fees. In each case, breadth is assumed to be tempered in comparison with the prophetic sponsor
500 and the estimate of the transfer coefficient for the in Case 1 that picks only good fund managers.
S&P 500 benchmark comes from applying Equation 13.
The picture becomes grimmer for this sponsor if fees are
Case 1 represents a plan sponsor, perhaps King taken into account. Case 2B is the same as Case 2A except
Arthur’s Round Table, Inc.—one whose founding seer, that it assumes a modest fee of 0.25%. After subtracting
Merlin, still sits on the investment committee. With this fee, the net expected alpha becomes negative. Fees
an IC Spon| Spon = 1.0, this sponsor has perfect ability to raise the bar on successful active management. Despite
see the future for all fund managers. This clairvoyant the fact that this fund manager is expected to be more
sponsor can fairly predict a gross-of-fee expected alpha right than wrong (the manager has a positive information
of 2.43% from this fund manager, resulting in an infor- coefficient of 0.005 from Equation 8), a minimum degree
mation ratio of about 0.50.27 of manager skill is required to overcome the drag from
fees, and this one does not meet the minimum. If the
sponsor hires this manager, it must expect to lose
a small amount of money.

Table 3
impact of sponsor skill and fees on expected fund manager alpha

Inputs Output

Variability Transfer alpha net
Case Score Sponsor skill of IC Breadth Active risk (%) Fees (%) coefficient (%) of fees (%)

(z Mgr|Spon ) (IC Spon|Spon ) (jICMgr | Spon ) (BrMgr |Spon ) (qMgr |Spon ) (Fees Mgr|Spon) (TCMgr |Spon ) (aMgr |Spon )
1 0.67 1.00 0.07 500 5.0 0.00 46 2.43
2A 0.67 0.10 0.07 500 5.0 0.00 46 0.24
2B 0.67 0.10 0.07 500 5.0 0.25 46 –0.01
3 0.67 0.40 0.07 500 5.0 0.25 46 0.72

27 Of course, an all-seeing sponsor would pick a better manager if the case gave the sponsor a richer sample to choose
from; this manager is barely top quartile.

june 2008 17
Finally, Case 3 is an optimistic but not unrealistic sponsor number of securities in the benchmark, although that
that believes that for every 10 fund managers it chooses, is not necessarily the case. The assumption means
7 will be good, for a p = 0.70, which translates to an that for the same process, the portfolio benchmarked
IC Spon|Spon of 0.40. This sponsor is also paying fees of 0.25%, to the Russell 3000 has three times the breadth of
so the expected after-fee net alpha is 0.72%. Although one benchmarked to the Russell 1000. Both portfolios
this is nowhere near as large a number as many sponsor are run at identical 2.0% active risk by the same fund
professionals would claim if they were simply asked to manager, who the sponsor believes has borderline top-
“ballpark” an expected alpha for such a fund manager, quartile skill. The sponsor in this example is modestly
it is a figure that can stand up to a discussion on many confident of its abilities to spot good fund managers
fronts—all of which are intimately related to the limits and, based on an expected win rate of 7 out of 10,
of the possible for how much alpha can be expected from assigns itself a sponsor information coefficient of
a portfolio given the (fairly realistic) portfolio character- 0.4. For the time being, we ignore fees and again
istics and investment process that we have assumed. assume = 0.07.

These cases throw light on the importance of skill in active Table 4 reveals some of the tradeoffs associated with
management. Although sponsors and fund managers are increasing the portfolio’s breadth. An increase in breadth
tempted to make overly optimistic alpha forecasts (3% expands the opportunity set and thus increases the
and 4% forecasts of expected alpha will often be casually expected alpha of a portfolio in proportion to its square
bandied about), actual realized returns for the portfolio of root. Benchmarks with more securities have lower average
fund managers seldom reach such high levels. Skill levels security weights, however, and thus allow smaller nega-
need to be considered when setting expectations but usu- tive positions for long-only portfolios. This is the same
ally are not. Invariably, expectations become more modest as saying that the transfer coefficients of the resulting
when sponsors are fully informed by following the Alpha- portfolios are lower. Using Equation 13, we estimate a
Builder forecasting process that fully incorporates skill 44% transfer coefficient for Russell 3000–based active
estimates and other important variables. portfolios, in comparison with a 62% transfer coefficient
for a Russell 1000–based portfolio, where both have 2%
Impact of Increasing Breadth active risk. This unhelpful relationship between breadth
To examine some of the tradeoffs associated with and the transfer coefficient in long-only portfolios opposes
increasing breadth, we consider two long-only US equity the helpful first-order effect of greater breadth. The first-
portfolios: Portfolio A is benchmarked to the Russell order effect of increasing breadth, however, being larger
1000 Index (large cap only), whereas Portfolio B is than the negative effect of a decreasing transfer coefficient,
benchmarked to the Russell 3000 Index (in essence, does prevail. Thus, all other things being equal, Portfolio B,
the whole US market). In this example, we’ll make the benchmarked to the Russell 3000, has a higher expected
simplifying assumption that breadth is equal to the alpha than Portfolio A, benchmarked to the Russell 1000.

Table 4
impact of increasing breadth on expected alpha

Inputs Output

Variability Transfer alpha net
Portfolio Score Sponsor skill of IC Breadth Active risk (%) Fees (%) coefficient (%) of fees (%)

(z Mgr|Spon ) (IC Spon|Spon ) (jICMgr | Spon ) (BrMgr |Spon ) (qMgr |Spon ) (Fees Mgr|Spon) (TCMgr |Spon ) (aMgr |Spon )
A 0.67 0.40 0.07 1,000 2.0 0.20 62 0.53
B 0.67 0.40 0.07 3,000 2.0 0.20 44 0.71

18 InvestmentInsights
Table 5
impact of lower manager skill and higher breadth on expected alpha

Inputs Output

Variability Transfer alpha net
Portfolio Score Sponsor skill of IC Breadth Active risk (%) Fees (%) coefficient (%) of fees (%)

(z Mgr|Spon ) (IC Spon|Spon ) (jICMgr | Spon ) (BrMgr |Spon ) (qMgr |Spon ) (Fees Mgr|Spon) (TCMgr |Spon ) (aMgr |Spon )
A 0.67 0.40 0.07 1,000 2.0 0.20 62 0.53
B 0.50 0.40 0.07 3,000 2.0 0.20 44 0.48

The example becomes even more interesting if the spon- grasp. Certainly, alpha estimation cannot be done without
sor assigns Portfolio B a lower z-score, z Mgr|Spon , than grappling with estimating these variables at some level.
Portfolio A, reducing it to 0.50. This might be the case if
We have provided a rational means for scaling the two
the fund manager relies on fundamental analysis but is
most difficult inputs—fund manager skill and the plan
staffed with only a few analysts, so its resources become
sponsor’s skill at selecting fund managers—and incor-
thinner with increased breadth, resulting in a decline in
porating these estimates with other important factors,
forecasting accuracy. Table 5 shows the effect. Portfolio A
such as active risk levels, breadth, fees, and so on. The
remains the same as in Table 4. The result is a decline in
approach is reassuringly familiar, in that it is based
expected alpha to 0.48% for the revised Portfolio B, now
entirely on two bits of comfortably well-accepted alpha-
less than the 0.53% predicted for Portfolio A despite the
forecasting methods—the Grinold forecasting equation
benefit of Portfolio B’s much larger breadth.
and the fundamental law of active management.
Therefore, increased breadth is useful only if the fund
As with all mathematical formalizations of an inherently
manager can sustain forecasting accuracy and intensity
subjective decision-making process, the numerical answer
over a larger universe of securities—that is, if the increased
may not be as important as the process itself. The man-
breadth is, in fact, being used effectively.
ager evaluation framework suggested here is, therefore,
analogous to a discounted cash-flow valuation model for
security selection: The model forces the user to think
Conclusion clearly about the validity and internal consistency of his
The ability to forecast expected alpha is one of the keys
or her assumptions, and to communicate those assump-
to successfully employing active fund managers and
tions effectively among the user’s colleagues. Although
deserves much more attention by sponsors. Sponsors
the final manager selection decision may also involve
need to proactively forecast alpha to ensure that their
factors not discussed here, the quantitative process of
portfolios of fund managers are not merely random
this framework itself is inherently valuable.
collections of past winners and losers.
Before playing any game, it helps (a lot!) to know the rules
Forecasting alpha is hard, but it can be done. The Alpha-
of the game. For the negative-sum game of hiring fund
Builder framework described here helps organize the
managers, the rules require at least two levels of well-
effort logically. It identifies the variables that affect
above-average skill. As in any game, there will be winners
expected alpha, thus breaking up the estimation problem
and there will be losers. The good news for those who
into pieces that are easier to estimate than fund manager
desire to be winners is that simply understanding the
skill taken as a whole. These variables, including spon-
rules and using them to guide one’s actions can give
sor information coefficient, active risk, breadth, and the
one a tremendous advantage over the competition.
transfer coefficient, are within the sponsor’s estimation

june 2008 19
Appendix: We know that the slope of the regression line indicated by
The sponsor’s version of this value says something about the skill of the sponsor
the forecasting equation in assigning z-scores. We can see this point more clearly
Assume we have a set of next-period estimated z-scores if we decompose the fitted slope term into its natural
for n fund managers, z Mgr (n)|Spon , all of whom are under component terms of covariance over variance and then
consideration or already employed by the sponsor. These further simplify it:
z-scores are unit-normal predictions made by and “owned”
jz IC
n, n
zn ;
by the sponsor about how good each particular fund man- 2 (A3)
ager will be [here, z Mgr (n)|Spon , is simplified to z n ].
jz n

Our intention is to use these forecasts to estimate the then,

fund manager’s actual, realized skill in the next period, zn
ICn= (rz )( ) (A4)
or IC Mgr (n)|Spon (simplified here to ICn). We will tease the n,
n j IC
jz n

required methodology out of the mathematics of regres-
sion analysis. The first term on the right in Equation A4, rz IC , is the
n, n
correlation between the sponsor’s forecast z-scores and
If we regressed the realized information coefficients of
the realized information coefficient of the manager, ICn .
the managers on the z-scores predicted by the sponsors
In our notation in the main text, this term is simply the
(we probably would not actually do this, but we could),
information coefficient of the sponsor itself, IC Spon|Spon .
we would be taking advantage of a relationship that has
The second term, IC , is also already in our notation as
the form j n
the cross-sectional variation in manager information
ICn= a + bzn+
en , (A1) coefficient, notated in the main text as
. And
because z is a normalized variable, z = 1 by construc-
which means that the next-period realized information
tion, so the final term is simply zn .
j n

coefficient of the fund manager is the value of the fitted

regression intercept, a, plus the product of the fitted slope, With these understandings, Equation A4 can be restated
b, times the sponsor’s estimated z-score for the manager, in the general form of the familiar forecasting equation but
plus or minus an error term. If the average information in a way that reflects its change in focus from estimating
coefficient and average z-score are both zero, consistent security alphas to estimating manager information coef-
with our understanding that this is a zero-sum game, then ficients. Going back to fully subscripted notation to avoid
a is also zero; we will make this assumption and will drop ambiguity, we have
the a term out of the equation.
IC Mgr|Spon = IC Spon|Spon zMgr|Spon . (A5)
The regression equation makes obvious the imperfections
jIC Mgr|Spon

Equation A5 means that the estimated information coef-

in the forecast, of course: The realized information coeffi-
ficient of the manager, in the view of the sponsor, is the
cients will include this pesky error term. But because the
information coefficient of the sponsor itself, times the cross-
error term itself has a zero expectancy by construction,
sectional volatility of manager skill, times the z-score of
we can drop it when considering our best estimate of (or
the manager as estimated by the sponsor. It is Equation
the expected) information coefficient. With this simpli-
8 in the main text, a fund manager–oriented version of
fication, we see that the best estimate of the next-period
the security-centric forecasting equation (compare with
information coefficient of the nth manager is really simply
Equation 6) presented in Grinold (1994) and Grinold and
the slope term, b, times the z-score given the manager:
Kahn (2000a), both of which are worthy of rereading for
ICn= bzn . (A2) their many wise insights about alpha.

20 InvestmentInsights
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Clarke, Roger, Harindra de Silva, and Steven Thorley. from Beta.” In Points of Inflection: New Directions for
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june 2008 21
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